The flight of the renminbi

Economic repression at home is causing more Chinese money to vote with its feet

IN 1980 Milton Friedman, a Nobel prize-winning economist and apostle of free markets, made his first visit to China. Unlike the typical traveller, he complained about the lack of tipping. Tips, after all, represent a price (the price of good service) and prices, Friedman firmly believed, should be left to perform their magic, drawing resources to their best use. Without them, he discovered, nothing will draw hotel porters to the aid of a weary American struggling with his suitcases.

Friedman argued that economic freedom was a necessary condition for political freedom. But in his 1962 book “Capitalism and Freedom” he conceded that economic freedom could advance without its political cousin. China’s outgoing leaders, Hu Jintao and Wen Jiabao, would no doubt agree. They have failed to push political reform during their time in office. But what about economic freedom?

The advance of free markets and private property is monitored by the Economic Freedom of the World index, which Friedman helped to devise with the Fraser Institute, a Canadian think-tank. In its latest report, published last month, it showed that economic freedom had increased during the Hu-Wen years. But China still sits below 99 countries in the rankings. For instance, Chinese people are still not entirely free to take capital out of the country, though many are trying to do so.

China’s remaining economic illiberalism is both costly and unpopular. Some of the costs have been calculated by another think-tank, Unirule, based in Beijing. (Its chairman, Mao Yushi, received this year’s Milton Friedman award for advancing liberty.) It calculates that China’s state-owned telecom firms have earned excess profits of about 31 billion yuan ($5 billion) a year, thanks to administrative barriers that shield them from competition. Their high prices have also deterred some customers who would have paid the market rate. These lost transactions are like the uncarried suitcases and unpaid tip at Friedman’s hotel, mutually beneficial exchanges that passed unconsummated. But in telecoms, the lost benefits were worth up to 442 billion yuan from 2003 to 2010.

Just as China’s state-owned firms overcharge their customers, its state-owned banks underpay their depositors. A mandatory ceiling on deposit rates deprives savers of the market return on their money. Unirule calculates the forgone interest amounted to about 1.16 trillion yuan in 2011, about 2.6% of GDP.

Voluntary exile

To escape this financial repression, savers have sought refuge first in the stockmarket and then in the property market. Now some are seeking financial asylum abroad. The Hurun Report, a marketing firm, reckons that wealthy Chinese (with over 10m yuan to their name) hold 19% of their assets overseas. (Hurun found that some 85% of them plan to send their children to school outside China and 44% have plans to emigrate themselves.)

Owning foreign property is no longer a dream limited to the super-wealthy. Some smallish investors are eyeing properties in second-tier American cities like Phoenix, Arizona. But what about capital controls, which limit Chinese citizens to taking out $50,000 a year? “I don’t really worry about that,” one investor says. “The Chinese are known for finding all sorts of channels for sending their money out of the country.”

Outflows of capital are hard to track, but they seemed unusually heavy this summer. Stephen Green of Standard Chartered, a bank, points out that inflows of foreign exchange from China’s trade surplus and (net) foreign direct investment amounted to about $108 billion in the third quarter. And yet only $28 billion appeared in China’s foreign-exchange reserves. That suggests about $80 billion flowed in the opposite direction. Some of this money flowed out of the yuan without leaving the country—foreign-currency deposits held by Chinese banks increased by $9 billion. The outflow also probably stopped in September, Mr Green says, as China’s economy improved. But the figures still suggest a summer of capital flight.

Mr Green’s calculations assume that China’s trade surplus is counted correctly. But firms can also spirit funds out of China by understating their exports and overreporting their imports. They may, for example, sell $1,000-worth of goods abroad, show an invoice for $800, and keep the remainder overseas.

Global Financial Integrity (GFI), an American research group that campaigns against illicit financial flows, believes this mis-invoicing is rampant. In a new study Dev Kar and Sarah Freitas of GFI compared China’s reported exports to the world with the world’s stated imports from China. They also juxtaposed China’s purchases from the world, with the world’s exports to China. In principle the figures should match. But the two economists found huge discrepancies between them (see chart). If, as Mr Kar and Ms Freitas recommend, China’s trade with Hong Kong and Macau is excluded, the country appears to have understated its exports and overstated its imports by a combined $430 billion in 2011.

These estimates are hard to take at face value. They imply that China’s true current-account surplus (which includes its trade surplus plus one or two other things) was almost 20% of GDP at its peak in 2007 (officially it was about 10%). But even if the figures are illustrative, rather than definitive, they highlight the difficulty of curbing the cross-border flow of capital in a country with such a heavy cross-border flow of goods.

The capital flight identified by GFI does not pose a macroeconomic danger. In some respects, its calculations imply that China’s external balances are even stronger than official figures suggest: for every dollar of capital flight their method posits, it also uncovers one extra dollar of hidden export earnings (or one less dollar spent on imports than officially reported).

This flight may not be a threat to macroeconomic stability, but it is surely a sign China’s new leaders should heed. Milton Friedman understood that the threat of exit sends a powerful signal. On his visit in 1980, he and his wife were unhappy to be marooned in a suburban hotel on the outskirts of Beijing. If they were not relocated, they would go home, they insisted. Two days later, they were moved to the best hotel in the city.